Arabies Trends: the crisis at shell: May 2004
Decline and fall
The mighty Royal Dutch/Shell Group is facing an unprecedented crisis of confidence. A special report on the scandal that is shaking up the energy giant.
By ED BLANCHE BEIRUT
Philip Watts, then chief of Royal Dutch/Shell’s exploration and production department, was a big hit when he appeared on stage at a gathering of the international oil giant’s top executives in Maastricht in June 1998. Making a grand entrance wearing a silver astronaut suit and riding a mock spaceship, he declared to rapturous applause: “I have seen the future, and it’s great.” For a company that was regularly posting net profits of more than $10 billion a year, that meant fat checks for executives and investors alike.
Six years later, on March 3, 2004, Watts, by then chairman of the board, was unceremoniously booted out, along with Walter van de Vivjer, who had Watts’s old job as head of exploration and production, amid intense pressure from angry shareholders. It was the corporate world’s most serious management
Head hunting. “On the face of it,” wrote financial analyst Oliver Morgan in the Observer, “the City’s corporate assassins . . . got their biggest scalp – and in double-quick time . . . Sir Philip Watts’s unseating is spectacular because of Shell’s reputation for haughty disdain toward outside pressure.” All this caused a grievous loss of confidence in the world’s third-largest publicly traded oil company, wiped $1.5 billion-plus off its stock market value and turned the energy industry on its head.
On January 9th, Shell confessed that it had overestimated its reserves of crude oil and natural gas by more than one-fifth – the equivalent of 3.9 billion barrels. That included 1.5 billion barrels that comprised 60 percent of the company’s Nigerian reserves and others in the offshore Gorgon gas field in Australian waters. The impact of that shock disclosure, the first of its kind involving one of the world’s oil majors, was catastrophic. The company’s shares tumbled and investors went ballistic, howling for Watts’s head.
On March 18th, Royal Dutch/Shell slashed its oil and gas reserves for the second time in as many months, cutting its end of 2002 reserves by 250 million barrels and wiping a further 220 million off 2003. Most of that was in the Norwegian sector of the North Sea. That raised the total loss of reserves to more than 4 billion barrels, well and truly bringing into question its accounting standards.
Then, in April, reports began to surface about Shell’s estimates of Omani oil reserves and, in particular, the success of the company’s horizontal drilling techniques in the sultanate. It appears that, in 2000, Shell dramatically overstated the figure for proven reserves and, perhaps even more ominously, raising the question asked by the New York Times: “whether new technology can extend the life of huge but mature fields.”
Before the Oman scandal broke, van de Vivjer’s successor as head of exploration and production, Malcolm Brinded, declared that his department was determined that the group “cannot stumble again in such a manner.” But he warned that there could be further reserve shortfalls since a “fast-track review” that resulted in the second downgrade had only covered 40 percent of Royal Dutch/Shell’s assets at that point in mid-March. The company delayed publication of its annual report, due on March 18th, until late May, supposedly to give independent auditors time to complete a review of all the company’s reserves. It also took the unprecedented step of postponing its annual meeting from April to June 28th, putting off a public confrontation with its outraged shareholders.
For energy companies, oil and natural gas reserves constitute a central asset and are a primary indicator of economic health. But companies have every incentive to boost reserve estimates – the more they can claim, the more competitive and attractive they are to investors, who along with industry analysts, see the figures as an indication of future profitability. Despite all the technological advances over the years, estimating proven reserves remains as much an art as a science, although there are extensive industry and government regulations that seek to ensure that these estimates are measured as precisely as possible.
Open and shut. The scandal over reserves has a particular resonance in the Middle East as countries there are increasingly opening up to foreign oil companies once more. It has also highlighted the oil companies’ practice of listing millions of barrels in oil reserves in states where they have hold no rights to oil and gas deposits.
Saudi Arabia recently signed exploration agreements with ENI of Italy, Repsol of Spain, Sinopec of China and Lukoil of Russia in a groundbreaking move nearly 30 years after nationalization. Kuwait is expected to follow suit and Libya, newly rehabilitated in the world community, is throwing open its doors to Western oil companies again.
The Royal Dutch/Shell scandal broke as the United States and Europe grappled with a plague of corporate corruption: Enron and Tyco International of the United States; Parmalat of Italy; France’s oil giant Elf; Norway’s Statoil; Halliburton, the US oil services company once run by Vice President Dick Cheney; and the $11 billion accounting fraud by WorldCom.
But the Shell scandal was notable because it broke new ground and has reverberated internationally in the strategic field of energy. The Anglo-Dutch oil giant may not be the only energy company that has misrepresented its reserves. On February 17th, the Houston-based El Paso Co. lowered its listed gas reserves by 51 billion cubic meters, slicing as much as $1 billion off the book value of its reserves. Other companies could follow suit as the Royal Dutch/Shell scandal swells. ExxonMobil, for instance, also has a stake in the Norway’s Orme Lange gas field, as does Norway’s state-owned Petoro and BP, and they may have to reevaluate their reserves there.
Criminal charges. Royal Dutch/Shell faces an investigation by the US Securities and Exchange Commission (SEC) that could result in civil charges. The US Department of Justice is investigating whether shareholders were intentionally misled and whether the company is criminally liable for failing to disclose a significant shortfall in its reserves.
Royal Dutch/Shell, with corporate headquarters in London and The Hague, could also face investigations for possible insider trading by the Autoriteit Financiele Markten, the Dutch financial regulatory body, although there does not appear to have been any such irregularities in that regard. Britain’s Financial Services Authority, which regulates publicly traded companies, is also conducting an investigation.
Watts is expected to be questioned in a lawsuit brought by a Philadelphia law firm, Berger & Montague, claiming unspecified monetary damages on behalf of the Ongoni tribe in Nigeria’s southern delta region for alleged human rights abuses by a Shell development company in the early 1990s. Watts was head of that subsidiary at the time.
The lawsuit alleges that Shell engaged in militarized commerce in a conspiracy with the former military government of Nigeria. It accused the company of “purchasing ammunition and using its helicopters and boats and providing logistical support for . . . a military foray into Ogoniland designed to terrorize the civilian population into ending peaceful protests against Shell’s environmentally unsound oil exploration.”
Shell’s London office said the allegations are “without foundation.” ChevronTexaco is accused of similar actions in 1998-99 in Nigeria, while Unocal and ExxonMobil of the United States face similar suits in other countries in Africa, Asia and Latin America. And as if all that were not enough, Shell is also looking at as many as seven class-action lawsuits in the United States from shareholders who allege it deliberately violated accounting regulations by misreporting its reserves in filings to the SEC.
Class action. One suit is being brought by one of America’s leading class-action law firms, Milberg Weiss Bershad Hynes and Lerach of New York, which said that Shell, by dropping its claim that the 3.9 billion barrels were registered as reserves in good faith – a position fiercely defended by Watts before his ouster – the company greatly strengthened the investors’ case.
In many ways, investors’ ire was directed as much against the oil giant’s arcane corporate structure, a relic of its imperial origins that date back to the 1890s. The ownership structure is highly unusual: 60 percent held by the Royal Dutch Petroleum Co., which is listed on the Dutch Stock Exchange, and 40 percent by Shell Transport & Trading, listed and based in London. Both have their own boards. Investors have been critical of this for years. Watts was chairman of a key central committee whose lack of accountability has long disturbed institutional investors. Executives and non-executives of the two boards meet together only rarely.
In the late 1990s, shareholders blamed this loose arrangement for Shell’s failure to act on takeover opportunities that followed a slump in oil prices and which BP and Exxon, the company’s great rivals, used to expand through acquisition. But despite the baying of investors and the slew of investigations into the company’s inner workings, few in corporate circles expect any major reforms that would sweep away the unwieldy dual structure in favor of a more streamlined American model. The stolid Dutch are considered to be seriously opposed to any significant changes, since that could endanger the delicate 60:40 balance of shareholdings in their favor.
Still, the pressure for reform is going to increase as the scandal grows and grows, and which has touched the Dutch side as well. Watts, who had been head of exploration and production from 1996-2001, when the mistakes were made, was replaced as chairman by Jeroen van der Veer, the group’s former vice chairman and the president of Royal Dutch Petroleum. Now there are allegations that van der Veer, a chemical engineer with such a modest public profile he is known in some quarters as “the low-flying Dutchman,” and the company’s chief financial officer, Judith Boynton, had known about the huge shortfalls in proven oil and gas reserves since February 2002, two years before they were publicly disclosed.
The New York Times quoted a company memorandum from that date as saying 1 billion barrels of reserves “are no longer fully aligned” with guidelines laid down by the SEC because the agency had clarified those regulations.
The memorandum, according to the Times, noted that a further 1.3 billion barrels of reserves were in jeopardy because it was no longer certain, under the clarified SEC regulations, that they could be extracted during the time remaining under the licenses between Anglo Dutch/Shell and three countries where it was operating. The newspaper, citing internal corporate memoranda, indicated that van der Veer and Boynton had received information about the shortfalls when they were members of a small committee of senior Shell executives headed by Watts. The documents in question are now in the hands of lawyers investigating the company.
The Times said that rather than disclose the problems to investors, senior executives, according to a July 2002 memorandum, came up with – and later carried out – what was described as an “external storyline” and “investor relations script” that tried to “highlight major projects fueling growth,” “stress the strength” of existing resources and “minimize the significance of reserves as a measure of growth.”
Shell officials have repeatedly pledged more openness to investors, but have still kept secret details of its reduction of reserves in Nigeria for fear of damaging its already strained ties with the government there. That could jeopardize efforts by Nigeria, the world s seventh largest oil producer, to persuade OPEC to significantly increase its oil production quota, and thus its revenues. Its current quota is 2 million barrels a day (b/pd), but it has a production capacity of 2.5 million b/pd and hopes to raise that to 4 million b/pd by 2010.
Nigeria’s oil exports account for 90 percent its revenues. Full disclosure by Shell would endanger Shell’s partnership with the Nigerian government, which is facing rising unrest in several regions, particularly in the Niger Delta, where most of Nigeria’s oil reserves are located. Political and ethnic violence resulted in a sharp reduction in production recently. Cutting costs. On March 22nd, Royal Dutch/Shell, reeling from the reserves scandal, announced a “strategic transformation” of its Nigerian operation. Company sources said that its 5,000-strong workforce could be cut by one-third in a cost-cutting drive, a development that could be explosive because Nigeria’s labor unions, old foes of Shell, are well organized and highly politicized. As it is, provincial authorities in Delta state have warned Shell they could shut down the company’s production there if it goes ahead with the plan.
The company’s embarrassment deepened on March 10th, when the small Scotland-based Cairn Energy announced a spectacular oil strike in a concession in India that the oil giant had sold it 18 months earlier for a meager $7 million. Royal Dutch/Shell may be able to reverse some of its setbacks with its March 25th announcement of a “long-term strategic relationship” with Libya, now reforging links with the West after decades of estrangement. The deal – involving exploration of new energy reserves and developing existing natural gas facilities – could be worth $200 million over the next five to seven years. Shell was active in Libya from the 1950s to 1974, producing around 300,000 barrels of oil a day. But it gradually reduced its presence and finally pulled out in 1992 when the United Nations Security Council imposed sanctions over the Pan Am Lockerbie bombing.
But the massive Shell accounting scandal is likely to reverberate for some time, and possibly spread further. That could strengthen the claim by a growing number of geologists and former oil company officials that global oil reserves may be dangerously exaggerated.